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Saturday, March 16, 2013

Income Tax law (There, I Fixed It)

With recent discussions on changes to the German income tax law,
especially regarding the splitting regulation for couples and
families, I grow continuously frustrated at politicians’ inability to
simplify the tax code. And it could be so easy.

Initial Considerations

Unfair Ideal of Fairness

It’s a recurring issue of tax codes that they put a lot of effort into
attempts of being fair. Most exceptions and loopholes in tax systems
are there to remedy a perceived unfair situation for someone. Every
single one of them can be argued for and makes sense in isolation, but
in total, they add up to a system that is so complex that you need
specialists to understand it, which is simply unfair towards those who
can not afford the specialists—the less wealthy.

But to fix this, you need to get rid of regulations every single one
of which helps someone out there, so every simplification will upset
someone. And that is something politicians would rather avoid. So we
are stuck with a horrible system.

Because of this, for every proposed system improvement, someone will
complain that it will treat them worse than the old system. So any
discussion about a new system should discuss specific parts of the
system on its own, and only ever the whole system in comparison with
the old.

Progressive and Regressive Tax Systems

Most income tax systems are progressive, meaning that people with
a higher income pay a higher tax rate than those with a lower income.
While the idea that this would lead to situations where earning more
results in actually receiving a lower absolute amount due to higher
tax rates is false as this is specifically avoided in most tax
systems, this can still be perceived as unfair: Why do some people pay
a higher percentage of their income and some people pay a lower
percentage than others, just because they earn more or less?

The reason for this is a result of the marginal utility of money.
The first Euro has a much higher value than the one millionth Euro.
Specifically, there is a certain amount of money that everyone needs
to pay just to survive. This includes basic food, housing, and
clothes. Let’s say you need 500 EUR per month for that. If someone
makes 500 EUR a month, and another 2000 EUR a month, charging a flat
25 % tax rate would leave the former with too little money to get by,
while the latter can easily afford it. This is can not be called a
“fair” tax in any way.

The same argument can be extended. Above this subsistence level,
there’s a level of comfortable living, versus luxurious living.
There’s a difference in unfairness between making the only vacation
someone might have in a year impossible, versus making the fifth
vacation impossible.

If you start with a tax level, any tax level, for the richest people,
each of those steps means that it would only be fair if the group
earning less than the current group should pay a smaller percentage of
their income in taxes. So maybe we should talk about lower taxes for
poorer people, not higher taxes for richer people. It means the same,
but might make more sense to some.

There’s a second reason for a progressive income tax, and that is that
the other major tax, the value-added tax or sales tax, is inherently
regressive. That is, the higher your income, the smaller the
percentage of it is paid to that tax. This is because the more income
you have, the smaller the percentage of it you pay for goods with a
sales tax. The income tax is the only tax that can be easily adjusted
to be progressive, so it can be argued that this is useful to balance
out the inherent unfairness of the other taxes.

A progressive tax system does not only have advantages, though. Such a
tax formula makes tax calculation more complicated, making it
difficult to know beforehand how much of a pay raise will actually be
available for you.

But the biggest problem for progressive tax system appears when you
consider tax deductions.

Deductions

A tax deduction is any amount of money you deduce from your income
before applying the tax formula. Tax deductions are usually the most
complicated part of any tax system, as it’s the easiest place to give
a special consideration for specific situations that are deemed to be
treated better by the state.

In a progressive tax system,
tax deductions are necessarily regressive.
The same amount of deduced money results in a larger amount of saved
money the more you earn. This is a completely silly effect,
considering that many of the tax deductions are meant to help poorer
people especially.

In a progressive tax system, it is therefore much more sensible to
reduce the tax debt after applying the tax formula, as that helps
everyone the same.

Goals

With these considerations, the goal for my income tax system is
primarily the redistribution of wealth to ensure that no one has to
live under the level of subsistence. While every bit of money earned
must result in a higher net income to encourage finding work, this
must not mean that anyone has to fear total poverty.

Beyond this primary goal, ruling parties can use the tax system to get
money for other projects, depending on their governmental philosophy.

Income Tax System

Types of Income

This system recognizes four types of income: Wages, profits,
investment, and a catch-all for other income.

Wages are from employment contracts where the wage is considered an
expense for a corporation or other employer, that is, where someone
else deduced the wage from their income before taxes. This avoids
double taxation. Legally required social security payments that are
withheld from the employee (jobless security, accident insurance,
etc.) are deduced from the income before taxes. Additionally, there is
a fixed deduction to account for private expenses related to getting
and keeping a job (currently 1,000 EUR in Germany). Making this a
fixed sum avoids a lot of complexity and special cases, at the expense
of some people with exceptional expenses being worse off.

Profits are from self-employed work, non-incorporated firms, rent or
leasing. In all of these cases, there are clear expenses related to
the relevant income. The taxable income from profits amounts to the
total income thereof minus the appropriate expenses. There are no
other deductions. This is probably the most complex income type, as it
requires definitions of what constitutes appropriate expenses.
Reforming this complex system in Germany is a matter for another post,
though, as it ties in with other business-related laws.

Investment covers all income made by lending money for interest,
anything from saving accounts to shares and stocks. This income has a
fixed deduction to protect small private savings (currently 801 EUR in
Germany), and no other deductions. Investment income is tricky. It is
the most volatile income type, and can quickly move to other
countries. A common approach, implemented recently also in Germany, is
to keep this type of income completely separate from all other income
types and apply a flat tax rate to encourage investment. The proposal
here follows that approach, as it is extremely simple and easy to
enforce.

Other income then includes every other source of income. Typical
examples are pensions, larger private sales, etc. These regularly have
specific laws defining them somewhere, and rarely have exceptions or
loopholes. For example, currently in Germany, pensions have a fixed
deduction of 102 EUR; similar fixed deductions can be defined for
other categories if necessary. As another example, private sales below
600 EUR do not need to be included. This is not a deduction; if you
sell something for 601 EUR, your taxable income increases by 601 EUR
from this sale. This is regularly a surprisingly simple part of income
tax law, so not really necessary to simplify much.

Deductions

Sadly, due to historical reasons in Germany, further tax deductions
can not be avoided completely. The sum of the income above therefore
has to be further reduced by a small and well-defined set of deducible
expenses.

In Germany, this has to include private retirement provisions (e.g.
“Riesterrente”). Also, donations to charities have a longstanding
tradition of being tax-exempt to encourage donations, so that likely
has to be kept as well.

All other deductions should be abolished and transformed into tax debt
deductions.

Tax Debt

The result of the above is subject to a tax formula and yields the tax
debt. The details of the tax formula are one of the easiest and most
effective places for the ruling parties to adjust this system.

Investment income is taxed completely separately from the rest at a
fixed and flat tax rate, again subject to the ideas of the ruling
parties. Currently, this would be 25 % in Germany.

Tax Debt Deductions

The resulting tax debt can be further reduced, down to 0, by whatever
other means the ruling parties consider necessary to support specific
situations. I’d recommend to keep this to a minimum, and I won’t
provide any recommendations, but it’s a possible way of adjusting the
system if deemed necessary.

Subsistence

The resulting tax debt then is directly reduced by the subsistence
level of the tax payer, and the subsistence level of any children in
their custody (only for one parent, obviously). This is special in
that it can reduce the tax debt below zero, in which case the tax
office pays out money instead of charging it. This unifies long-term
jobless payments (ALG II), social help, student loans, and various
tax-free subsistence levels of the income tax into a single,
well-understood system.

Subsistence levels are calculated by an appropriate method. Currently
in Germany, this uses average expenses of families with a specific
income level, but I’m open to improvements there. What is important is
that this results in a general subsistence level for adults and
children, for everything but housing (currently 4,584 EUR in Germany
for adults)

The cost of housing varies drastically between regions, and as such is
defined by the municipality the tax payer lives in. This uses a
percentage of the average rent for a single person in the
municipality. Contrary to the current ALG II method the value is
independent of the actual expenses to reward finding cheaper housing.

The general subsistence level is paid by the state while the housing
is paid for by municipalities, at least to some percentage. This
encourages municipalities to implement regulations that provide
affordable housing to keep this cost down.

With subsistence levels covered like this, the progressive income tax
rate can start at 0 EUR income and can be quite steep (say 50 %) until
the subsistence payments are balanced out.

The subsistence levels are again a way where the ruling parties can
influence the system without making it much more complex. As a good
example, disabilities could increase the subsistence level to some
degree.

Other deductions of the German tax system should almost all be
abolished. Single parents should already have a sensible basic level
of support by the above, any further money should go into the
availability of cost-free day care facilities, as these provide work
and allow parents to work as well. Likewise, school and education
expenses should not be handled on the level of the income tax but
subsidized to schools and universities directly.

Example Calculation

The numbers here are just examples, obviously. Exact numbers can be
adjusted by policymakers as necessary.

Let’s say there’s Tom. Tom currently has no job. The subsistence level
is at 4,584 EUR and the subsidized housing cost in his municipality is
3,546 EUR a year, resulting in 8,130 EUR a year of total subsistence
cost. He goes to the tax office and notifies them that he expects no
income this year. The tax office then will transfer 678 EUR a month to
his account.

A few months and many job applications later, Tom actually is hired
for one day a week, earning 300 EUR a month. His employer notifies the
tax office, which calculates that Tom’s total taxable income will be
3,600 EUR a year, minus the fixed 1,000 EUR deduction being 2,600 EUR.
The tax is set so that initial tax rates are at a steep 50 % until the
tax debt is zero, after which a multi-bracket system starts with 10%,
going up again as the taxable income increases. So right now, he pays
50 % taxes, or 1,300 EUR. But that tax debt is again reduced by his
subsistence level of 8,130 EUR a year, still resulting in 6,830 EUR
payment from the tax office, or 570 EUR a month. This means that Tom
now earns 870 EUR a month, or 192 EUR more than before. Even his small
amount of work paid off.

The more work Tom finds, the more money he will have in the end, even
though added payments from the tax office go down. Due to the 50 %
initial tax rate, he gets monthly transfers from the tax office until
he earns 17,260 EUR a year, or 1,439 EUR a month. Incidentally, this
is just below the full-time pay of someone earning the minimum wage of
8,50 EUR currently being discussed (17,740 EUR). At that point, every
further euro earned is taxed by 10 % and up to the next bracket, etc.
as usual.

Expanding the System

This system has a few well-defined and clear places where different
governments and parties can adjust it to fit their political idea.

The subsistence level can be changed up and down depending on the
ruling parties’ ideas of how much encouragement people need to work.
The tax levels and brackets can be adjusted depending on how high the
tax burden on the citizens should be, or how progressive the tax
should to be. These are all simple but effective ways of adjusting the
system to a political agenda without making it any more complex than
it is.

Still, I fully expect certain corner cases to crop up that this very
simple system does not cover well at all. Those would either add undue
burden to citizens or not respect certain aspects of the constitution.
Such special cases should be added as tax debt deductions if at all
possible, and be kept as simple as possible, favoring lump sums and
flat rates over detailed calculations.

But in any case, I’d like to caution against adding complexity. The
tax system affects everyone, and the more complex it is, the more
difficult it is for everyone to deal with it. Try to add things only
if absolutely necessary.

And most importantly, the income tax system is not a place to reward
or punish specific activities. Doing so only complicates things for
everyone. Many of the current special cases in Germany are so-called
“tax presents” for special groups. Don’t fall for this again in the
future. Instead of income tax changes, add specific bonus payments or
investments by the state for such activities. This is not much more
complicated for the individual requesting them, but much simpler for
the rest.

Summary

I have proposed a very simple tax system which ensures that every
citizen can live above subsistence level. Additionally, the tax system
ensures that every bit of income increases the available income,
giving strong incentive to all citizens at all times to find more
work.

The system also provides a number of well-defined regulatory settings
that the government can use to adjust it to their philosophy without
increasing the system’s complexity at all.

If implemented in Germany, this system could replace the current
income tax, the long-term jobless help (ALG II), social help systems,
child money, education aid (BAFöG) and a number of other ways in which
the state tries to help people in need, reducing administrative costs
tremendously.

But the simplicity has some problems. Simplifying a tax code always
results in some situations being more unjust than before. Sometimes, a
small injustice has to be accepted to avoid undue complexity. But if
the injustice is too large and no solution can be found outside of the
income tax code, it is still possible to adjust this system. But it’s
preferable to do this outside of the income tax to keep complexity
down.